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GLAD > SEC Filings for GLAD > Form 10-K on 20-Nov-2013All Recent SEC Filings

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Form 10-K for GLADSTONE CAPITAL CORP


20-Nov-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following analysis of our financial condition and results of operations should be read in conjunction with our accompanying Consolidated Financial Statements and the notes thereto contained elsewhere in this Annual Report on Form 10-K. Historical financial condition and results of operations and percentage relationships among any amounts in the financial statements are not necessarily indicative of financial condition or results of operations for any future periods. Except per share amounts, dollar amounts are in thousands unless otherwise indicated.

OVERVIEW

General

We were incorporated under the Maryland General Corporation Law on May 30, 2001. We operate as an externally managed, closed-end, non-diversified management investment company, and have elected to be treated as a business development company ("BDC") under the Investment Company Act of 1940, as amended (the "1940 Act"). In addition, for federal income tax purposes we have elected to be treated as a regulated investment company ("RIC") under the Internal Revenue Code of 1986, as amended (the "Code"). As a BDC and a RIC, we are subject to certain constraints, including limitations imposed by the 1940 Act and the Code.

We were established for the purpose of investing in debt and equity securities of established private business operating in the United States ("U.S."). Our investment objectives are to: (1) achieve and grow current income by investing in debt securities of established businesses that we believe will provide stable earnings and cash flow to pay expenses, make principal and interest payments on our outstanding indebtedness and make distributions to stockholders that grow over time; and (2) provide our stockholders with long-term capital appreciation in the value of our assets by investing in equity securities of established businesses that we believe can grow over time to permit us to sell our equity investments for capital gains. To achieve our investment objectives, our investment strategy is to invest in several categories of debt and equity securities, with each investment generally ranging from $5 million to $30 million, although investment size may vary, depending upon our total assets or available capital at the time of investment. We also aim to maintain a portfolio allocation of approximately 95.0% debt investment and 5.0% equity investment, at cost.

We focus on investing in small and medium-sized private businesses in the U.S. that meet certain criteria, including, but not limited to, the following: the potential for growth in cash flow, adequate assets for loan collateral, experienced management teams with a significant ownership interest in the borrower, profitable operations based on the borrower's cash flow, reasonable capitalization of the borrower (usually by leveraged buyout funds or venture capital funds) and, to a lesser extent, the potential to realize appreciation and gain liquidity in our equity position, if any. We lend to borrowers that need funds to finance growth, restructure their balance sheets or effect a change of control. We invest by ourselves or jointly with other funds and/or management of the portfolio company, depending on the opportunity. If we are participating in an investment with one or more co-investors, our investment is likely to be smaller than if we were investing alone.

In general, our investments in debt securities have a term of no more than seven years, accrue interest at variable rates (based on the London Interbank Offered Rate ("LIBOR")) and, to a lesser extent, at fixed rates. We seek debt instruments that pay interest monthly or, at a minimum, quarterly, have a success fee or deferred interest provision and are primarily interest only with all principal and any accrued but unpaid interest due at maturity. Generally, success fees accrue at a set rate and are contractually due upon a change of control in the business. Some debt securities have deferred interest whereby some portion of the interest payment is added to the principal balance so that the interest is paid, together with the principal, at maturity. This form of deferred interest is often called paid-in-kind ("PIK") interest.


Typically, our equity investments consist of common stock, preferred stock, limited liability company interests, or warrants to purchase the foregoing. Often, these equity investments occur in connection with our original investment, recapitalizing a business, or refinancing existing debt.

We are externally managed by our investment advisor, Gladstone Management Corporation (the "Adviser"), a Securities and Exchange Commission ("SEC") registered investment adviser and an affiliate of ours, pursuant to an investment advisory and management agreement (the "Advisory Agreement"). The Adviser manages our investment activities. We have also entered into an administration agreement (the "Administration Agreement") with Gladstone Administration, LLC (the "Administrator"), an affiliate of ours and the Adviser, whereby we pay separately for administrative services.

Our shares of common stock and term preferred stock are traded on the NASDAQ Global Select Market ("NASDAQ") under the trading symbols "GLAD" and "GLADP," respectively.

Business Environment

The strength of the global economy and the U.S. economy in particular, continues to be uncertain and volatile. Recently, we experienced the first U.S. government shutdown in 17 years along with a stalemate in the U.S. Congress over whether to raise the debt ceiling. The U.S. government budget concerns remain until early 2014 when the U.S. Congress will revisit the debt ceiling debate again. Prior to this recent U.S. fiscal crisis, economic conditions generally appeared to be improving, albeit slowly, since the 2008 recession. We have continued to remain cautious about a long-term economic recovery. The impacts from the 2008 recession in general, and the resulting disruptions in the capital markets in particular, have had lingering effects on our liquidity options and increased our cost of debt and equity capital. Many of our portfolio companies, as well as those small and medium-sized companies that we evaluate for investment, are still feeling the adverse impacts of these political and economic conditions, and if these conditions persist, it may affect their ability to repay our loans or engage in a liquidity event, such as a sale, recapitalization or initial public offering. These political and economic conditions could also disproportionately impact some of the industries in which we have invested, causing us to be more vulnerable to losses in our portfolio, which could cause the number of our non-performing assets to increase and the fair market value of our portfolio to decrease.

In addition, there has been increased competitive pressure in the BDC and investment company marketplace for senior and senior subordinated debt, resulting in lower yields for increasingly riskier investments. We believe we are in a protracted economic recovery; however, we do not know if market conditions will continue to improve or if adverse conditions will again intensify, and we do not know the full extent to which the inability of the U.S. government to address its fiscal condition in the near and long term will affect us. If market instability persists or intensifies, we may experience difficulty in raising capital. In summary, we believe that are in a protracted economic recovery, but that the recent U.S. fiscal crisis has temporarily suppressed that recovery. We do not know the full extent to which the impact of the lingering recessionary economic conditions will affect us or our portfolio companies.

Portfolio Activity

While conditions remain somewhat challenging in the marketplace, we are seeing a number of new investment opportunities that are consistent with our investment objectives and strategies. During the year ended September 30, 2013, we invested in 15 new proprietary and syndicate investments totaling $80.4 million; however, we experienced a net contraction in our overall portfolio of three portfolio companies, primarily due to 14 portfolio companies paying off early during the year, for an aggregate of $79.6 million in unscheduled payoffs. Subsequent to September 30, 2013, we invested $7.0 million in one new proprietary investment, as discussed under "Investment Highlights."

In addition, in July 2012, the SEC granted us an exemptive order that expands our ability to co-invest with certain of our affiliates by permitting us, under certain circumstances, to co-invest with Gladstone Investment Corporation ("Gladstone Investment") and any future business development company or closed-end management investment company that is advised by the Adviser (or sub-advised by the Adviser if it controls the fund) or any combination of the foregoing subject to the conditions in the SEC's order. We believe this ability to co-invest will enhance our ability to further our investment objectives and strategies. We co-invested with Gladstone Investment in two new proprietary investments-one in each of May and October 2013, as discussed under "Investment Highlights."


Regulatory Compliance

Challenges in the current market are intensified for us by certain regulatory limitations under the Code and the 1940 Act, as well as contractual restrictions under the agreement governing our $137.0 million revolving line of credit (our "Credit Facility," described more fully under "Revolving Credit Facility" below) that further constrain our ability to access the capital markets. To qualify to be taxed as a RIC, we must distribute at least 90.0% of our "investment company taxable income," which is generally our net ordinary income plus the excess of our net short-term capital gains over net long-term capital losses. Because we are required to satisfy the RIC annual stockholder distribution requirement, and because the illiquidity of many of our investments makes it difficult for us to finance new investments through the sale of current investments, our ability to make new investments is highly dependent upon external financing. Our external financing sources include the issuance of equity securities, debt securities or other leverage, such as borrowings under our Credit Facility. Our ability to seek external debt financing, to the extent that it is available under current market conditions, is further subject to the asset coverage limitations of the 1940 Act that require us to have an asset coverage ratio (as defined in
Section 18(h) of the 1940 Act) of at least 200.0% on our senior securities representing indebtedness and our senior securities that are stock, to which we refer collectively as "Senior Securities."

We believe that market conditions have affected the trading price of our common stock and our ability to finance new investments through the issuance of equity. On November 18, 2013, the closing market price of our common stock was $9.44, a 3.9% discount to our September 30, 2013, net asset value ("NAV") per share of $9.81. When our stock trades below NAV per common share, as it has consistently traded over the last four years, our ability to issue equity is constrained by provisions of the 1940 Act, which generally prohibits the issuance and sale of our common stock below NAV per common share without stockholder approval, other than through sales to our then-existing stockholders pursuant to a rights offering. At our annual meeting of stockholders held on February 14, 2013, our stockholders approved a proposal which authorizes us to sell shares of our common stock at a price below our then current NAV per common share subject to certain limitations (including, but not limited to, that the number of shares issued and sold pursuant to such authority does not exceed 25.0% of our then outstanding common stock immediately prior to each such sale) for a period of one year from the date of approval, provided that our board of directors (our "Board of Directors") makes certain determinations prior to any such sale. At the upcoming annual stockholders meeting scheduled for February 13, 2014, our stockholders will again be asked to vote in favor of renewing this proposal for another year.

The current uncertain and volatile economic conditions may also continue to cause the value of the collateral securing some of our loans to fluctuate, as well as the value of our equity investments, which has impacted and may continue to impact our ability to borrow under our Credit Facility. Additionally, our Credit Facility contains covenants regarding the maintenance of certain minimum loan concentrations and net worth, which are affected by the decrease in value of our portfolio. Failure to meet these requirements would result in a default which, if we are unable to obtain a waiver from our lenders, would cause an acceleration of our repayment obligations under our Credit Facility. As of September 30, 2013, we were in compliance with all of our Credit Facility's covenants.

We expect that, given these regulatory and contractual constraints in combination with current market conditions, debt and equity capital may be costly for us to access in the near term. However, we believe that our recent amendments to our Credit Facility to decrease the interest rate on advances and extend its maturity until 2016 and our ability to co-invest with Gladstone Investment and certain other affiliated investment funds, should increase our ability to make investments in businesses that we believe will be generally resistant to a recession and, as a result, will be likely to achieve attractive long-term returns for our stockholders. See "Recent Developments" for more information on these transactions. Going into fiscal 2014, we will continue to focus on building our pipeline and making investments that meet our objectives and strategies and that provide appropriate returns, given the risks.

Investment Highlights

During the year ended September 30, 2013, we invested an aggregate of $80.4 million in 15 new portfolio companies and an aggregate of $9.7 million to existing portfolio companies. Also, during the year ended September 30, 2013, we sold our investments in two portfolio companies for net proceeds of a combined $6.6 million, and we received scheduled and unscheduled contractual principal repayments of a combined $110.5 million from existing portfolio companies, including 14 early payoffs. Since our initial public offering in August 2001, we have made 342 different loans to, or investments in, 172 companies for a total of approximately $1.2 billion, before giving effect to principal repayments on investments and divestitures.


Investment Activity

During the year ended September 30, 2013, we executed the following transactions with certain of our portfolio companies:

Issuances and Originations

During the year ended September 30, 2013, we invested an aggregate of $50.2 million to five new proprietary portfolio companies and an aggregate of $30.2 million in 10 new syndicated portfolio companies (Ardent Medical Services, Inc., Blue Coat Systems Inc., First American Payment Systems, L.P., John Henry Holdings, Inc., New Trident Holdcorp, Inc., RP Crown Parent, LLC, Steinway Musical Instruments, Inc., SumTotal Systems, Inc., Wall Street Systems Holdings, Inc., and W3, Co.). We also invested in additional equity in RBC Acquisition Corp. ("Reliable") and Midwest Metal Distribution, Inc. ("Midwest Metal"). Below are significant issuances and originations during the year ended September 30, 2013:

In December 2012, we invested $14.0 million in AG Transportation Holdings, LLC ("AG Trucking") through a combination of senior subordinated term debt and equity. AG Trucking, headquartered in Goshen, Indiana, is a regional food-grade liquid and dry bulk carrier providing a variety of bulk transportation services, including liquid transportation, dry bulk dumps, freight brokering, private fleet conversion and project runs to large international agricultural and food manufacturing firms.

In December 2012, we invested $19.5 million in Allen Edmonds Shoe Corporation ("Allen Edmonds") through senior subordinated term debt that we purchased from one of Allen Edmonds' existing lenders. Allen Edmonds, headquartered in Port Washington, Wisconsin, manufactures premium men's footwear and accessories, which it sells through its retail stores, catalog and internet site and also wholesale and e-commerce channels.

In March 2013, we acquired a controlling equity position in Reliable and invested $2.0 million in additional equity capital in the form of preferred equity. In addition, we invested $0.3 million in preferred equity in August 2013 and an aggregate of $1.1 million in line of credit draws to Reliable during the year ended September 30, 2013. As of September 30, 2013, Reliable was classified as a Control portfolio company. Reliable was known as Reliable Biopharmaceutical Holdings, Inc. before its recapitalization in March 2013 and is therefore included on our accompanying Consolidated Schedule of Investments as of September 30, 2012 under the name Reliable Biopharmaceutical Holdings, Inc.

In May 2013, we invested $8.8 million in Funko, LLC ("Funko"), through a combination of senior subordinated term debt and equity. Funko, headquartered in Lynnwood, WA, is a designer, importer and marketer of pop-culture collectibles. This was our first co-investment with our affiliate fund, Gladstone Investment, pursuant to the aforementioned exemptive order granted by the SEC. Gladstone Investment invested an additional $8.8 million in Funko under the same terms as us.

In July 2013, we invested $8.9 million in Ashland Acquisition, LLC ("Ashland") through a combination of senior term debt and common equity, where we hold 20.0% of the voting securities. Ashland, through its wholly-owned subsidiary that is headquartered in Ashland, Ohio, provides publishing services including digital and offset printing, warehousing, distribution, and content and marketing services.

Repayments and Exits

During the year ended September 30, 2013, 34 borrowers made principal repayments totaling $110.5 million in the aggregate, consisting of $103.1 million of unscheduled principal and revolver repayments, as well as $7.4 million in contractual principal amortization. Below are significant repayments and exits during the year ended September 30, 2013:

Included in the unscheduled principal payments were the net proceeds at par from early payoffs of the following:

Syndicated investment payoffs: Airvana Network Solutions, Inc. of $0.2 million; Applied Systems, Inc. of $1.0 million; Blue Coat Systems, Inc. of $8.5 million; HGI Holdings, Inc. of $1.6 million; Hubbard Radio, LLC of $0.5 million; John Henry Holdings, Inc. of $5.0; Keypoint Government Solutions, Inc. of $6.4 million; Mood Media Corporation of $8.0 million; National Surgical Hospitals Inc. of $1.6 million; Springs Window Fashions, LLC of $7.0 million; SRAM, LLC of $2.5 million and Wall Street Systems Holdings, Inc. of $3.0 million. In connection with eight of these early payoffs, we received an aggregate of $0.9 million in prepayment fees during the year ended September 30, 2013.

Proprietary investment payoffs: Westlake Hardware, Inc. ("Westlake") of $20.0 million in December 2012 and CMI Acquisition, LLC ("CMI") of $14.4 million in September 2013. In relation to the Westlake and CMI early payoffs at par, we received $1.1 million and $0.6 million, respectively, in success fees during the year ended September 30, 2013.



In November 2012, we sold our investments in Viapack, Inc. ("Viapack") for net proceeds of $5.9 million, which resulted in a realized loss of $2.4 million recorded in the three months ended December 31, 2012. Viapack was partially on non-accrual status at the time of the sale.

In November 2012, we wrote off our investment in Access Television Network, Inc. ("Access TV"), which resulted in a realized loss of $0.9 million recorded in the three months ended December 31, 2012. Access TV was on non-accrual status at the time of the write off.

In April 2013, we sold our investment in Kansas Cable Holdings, Inc. ("KCH") for net proceeds of $0.6 million, which resulted in a realized loss of $2.9 million recorded in the three months ended June 30, 2013. KCH was on non-accrual status at the time of the sale.

In September 2013, we sold substantially all of the assets in Lindmark Acquisition, LLC ("Lindmark") for net proceeds of $14.4 million, which paid down our debt investments in full at par. Lindmark was on non-accrual status at the time of the repayment.

Refer to Note 16-Subsequent Events in the accompanying Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for investment activity occurring subsequent to September 30, 2013. Of note, the following significant new origination occurred subsequent to September 30, 2013:

In October 2013, we invested $7.0 million in Alloy Die Casting Co. ("ADC") through a combination of senior term debt and equity. ADC, headquartered in Buena Park, CA, is a manufacturer of high quality, finished aluminum and zinc castings for aerospace, defense, aftermarket automotive and industrial applications. This was a co-investment with Gladstone Investment, which invested an additional $16.3 million in ADC under the same terms as us.

Recent Developments

Notes Receivable from Employees

In July 2013, we received $1.0 million in full repayment of the outstanding principal and accrued interest owed on our employee note receivable from our chairman, chief executive officer and president, David Gladstone. Simultaneously, Mr. Gladstone's related redemption agreement was terminated pursuant to its terms.

Amendment of Credit Facility

On April 26, 2013, we, through our wholly-owned subsidiary, Gladstone Business Loan, LLC ("Business Loan"), entered into Amendment No. 6 to our Credit Facility to extend the maturity date for one year to January 19, 2016. We incurred fees of $0.7 million in April 2013 in connection with this amendment, which are being amortized through the maturity date of our Credit Facility. All other terms of our Credit Facility remained generally unchanged at the time of this amendment.

On January 29, 2013, we, through Business Loan, entered into Amendment No. 4 to our Credit Facility to remove the one month London Interbank Offered Rate ("LIBOR") minimum of 1.5% on advances. We incurred fees of $0.6 million in January 2013 in connection with this amendment, which are being amortized through the maturity date of our Credit Facility. All other terms of our Credit Facility remained generally unchanged at the time of this amendment.

Registration Statement

On November 29, 2012, we filed a universal shelf registration statement (our "Registration Statement") on Form N-2 (File No. 333-185191) that was amended on January 17, 2013, and which the SEC declared effective on January 18, 2013. Our Registration Statement permits us to issue, through one or more transactions, up to an aggregate of $300.0 million in securities, consisting of common stock, preferred stock, subscription rights, debt securities and warrants to purchase common stock or preferred stock, including through a combined offering of such securities. We have not issued any securities to date under our Registration Statement.


Executive Officers

On April 9, 2013, our Board of Directors appointed Melissa Morrison, the Company's then current chief accounting officer, as chief financial officer. Concurrently, David Watson resigned as the chief financial officer of the Company to focus on his position as the Company's treasurer and on his position as chief financial officer and treasurer for Gladstone Investment, an affiliate of the Company.

On February 5, 2013, our Board of Directors appointed David Gladstone as the Company's interim president to fill the vacancy created by the resignation of George Stelljes III, effective January 31, 2013, the Company's former president, chief investment officer and a director. Mr. Gladstone will hold this position until our Board of Directors finds a suitable replacement. Mr. Gladstone founded the Company and has also served as the chairman of our Board of Directors and the Company's chief executive officer since its inception in 2001.

RESULTS OF OPERATIONS

Comparison of the Year Ended September 30, 2013 to the Year Ended September 30, 2012

                                                           For the Year Ended September 30,
                                                  2013           2012          $ Change        %Change
INVESTMENT INCOME
Interest income                                 $ 33,533       $  36,077       $  (2,544 )         (7.1 )%
Other income                                       2,621           4,245          (1,624 )        (38.3 )

Total investment income                           36,154          40,322          (4,168 )        (10.3 )

EXPENSES
Base management fee                                5,622           6,165            (543 )         (8.8 )
Incentive fee                                      4,343           4,691            (348 )         (7.4 )
Administration fee                                   647             753            (106 )        (14.1 )
Interest expense on borrowings                     3,182           4,374          (1,192 )        (27.3 )
Dividend expense on mandatorily redeemable
preferred stock                                    2,744           2,491             253           10.2
Amortization of deferred financing fees            1,211           1,243             (32 )         (2.6 )
Other expenses                                     1,540           2,609          (1,069 )        (41.0 )

Expenses before credits from Adviser              19,289          22,326          (3,037 )        (13.6 )
Credits to fees from Adviser                      (1,521 )        (1,048 )          (473 )        (45.1 )

Total expenses net of credits                     17,768          21,278          (3,510 )        (16.5 )

NET INVESTMENT INCOME                             18,386          19,044            (658 )         (3.5 )

REALIZED AND UNREALIZED GAIN (LOSS)
Net realized loss on investments                  (5,231 )       (12,819 )         7,588           59.2
Net unrealized appreciation (depreciation)
of investments                                    15,673         (11,194 )        26,867             NM
Net unrealized depreciation (appreciation)
of other                                           3,391          (3,039 )         6,430             NM

Net gain (loss) from investments and other        13,833         (27,052 )        40,885          151.1

NET INCREASE (DECREASE) IN NET ASSETS
RESULTING FROM OPERATIONS                       $ 32,219       $  (8,008 )     $  40,227             NM

PER BASIC AND DILUTED COMMON SHARE
Net investment income                           $   0.88       $    0.91       $   (0.03 )         (3.3 )

Net increase (decrease) in net assets
resulting from operations                       $   1.53       $   (0.38 )     $    1.91             NM

NM = Not Meaningful

Investment Income

Total interest income decreased by 7.1%, which was driven by a decrease of $2.4 million or 6.7% on interest income on our investments in debt securities for the year ended September 30, 2013, as compared to the year ended September 30, 2012. This was primarily due to the increase in early payoffs at par during the year, . . .

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